This is an answer to a question posted to me in Zillow.com. A homeowner in Southern California was pondering a 5/1 FHA ARM with their loan officer. Of course it’s sad to me that one would have to turn to a bunch of strangers on a website to ask this question when their LO should be able to provide this information (but it doesn’t surprise me knowing as many loan officers as I have over the years). Anyways, here’s my answer…
I’m going to have to make a couple small estimates without knowing everything (which I could not know without actually having an application and ordering some documents from HUD) but this should be pretty close to accurate give when you’ve told us.
Right now your P&I + MI is $4147.02. As an estimate I used $457,000 as a new loan balance, should you be able to refinance into a 5/1 ARM at 3.85%, and came up with a P&I of $2142.45 + MI of $342.75 for a total of $2,485.20 and a difference of $1,661.82 a month!
Looking at this we know that the FHA 5/1 ARM is fixed for 5 years and can change by a maximum of 1% every year after the first 5 years. So it would actually be a full 7 years before the rate could increase to what it is today, a full 8 years before it could be higher than it is today, worst case scenario. So we’re looking at a 5/1 ARM with close to 8 years of rate safety. Not too bad.
Lets dig further… So you’re saving $1,661.82 a month for the first 60 months of this loan. If you were to be disciplined and save this for those 60 months, even if you earned NO interest you would have saved about $100,000 compared to your current payment before the payment could adjust even 1%. Over 8 years, by the time your payment could be more than it is today, you’d have saved about $140,000. Again, this is while earning NO interest on that money along the way (which you obviously wouldn’t do).
So, worst case, 8 years from now you have $140,000 (probably a lot more) saved and your payment has finally risen to be slightly higher than it was in 2011. Will the market have recovered enough to sell? I don’t know but I’d assume so. Has your income increased? Again we don’t know but we can pretty safely assume so. If not, you have $140,000 in the bank to bridge the gap now that, 8 years later, your payment is finally higher than it was in 2011.
Again this is not taking into account tax savings, compounding interest on the money saved, the fact that your rate is not guaranteed to increase by 1% annually (it can be less, or even go down), or the fact that you’ll also be paying down principal faster, etc. I’m looking at this very conservatively, the wealth building opportunity could, and probably would, be even bigger.
I would asses the refinance with your financial planner and create a plan, a plan you will force yourself to stick to, if you want to make the most of it. Maybe you only save $1,000 a month from the $1,661 and use the other $661 for whatever you want. You’d still save $60,000 over the first five years and put another $40,000 in your pocket for whatever you want to do. Either way the 5/1 FHA ARM is a great opportunity if utilized correctly, as I illustrated in the above scenario.